Guided Retirement Income Planning- Chapter 18

As you may recall in Chapter 11, we focused on converting assets into income. There were three approaches that we introduced: systematic withdrawals, bucketing and flooring. While they all demand attention, we find that the flooring strategy is least understood because of the use of annuities. Therefore, we need to discuss their value.

A number of income sources are used to establish a “floor” to cover essential spending needs that may include social security, pensions, and annuities. So let us dispel potential myths that may come to mind.

Annuities are generally misunderstood and sometimes unfairly criticized by certain financial organizations and the media. Thus, consumers are influenced and susceptible to herding or anchoring biases. Annuities are designed for many different purposes, which adds complexity and leads to confusion. Like social security and other forms of pensions, these insured income streams can form a reliable flooring strategy.

Annuities are offered by insurance companies and can be used in either tax-qualified or non-qualified accounts. Not all annuities are suitable and necessarily good products. A seasoned annuity specialist or financial advisor can evaluate the products in order to offer suitable options. The list below highlights different annuities and their distinctions:

• Single premium immediate annuities (SPIA) – Income for life annuities where income payments begin within thirteen months of the initial premium. There are different payment options with different levels of guarantees. Non-qualified immediate annuities can offer tax advantages for distributions each year.
  
  
• Deferred income annuities (DIA) – Fixed annuity products where income payments start sometime in the future. They offer interest rate returns.
  
  
• Single premium deferred annuity (SPDA) – Similar to a tax-deferred CD. Taking income is not required in a non-qualified account. These products are offered with different and variable levels of guarantees.
  
  
• Multi-year fixed term annuities – Like an SPDA, these will have guaranteed interest rates. However, the terms range from 3 – 10 years.
  
  
• Variable annuities (VA) – Policies allow people to invest in sub-accounts, similar to mutual funds, and they are therefore subject to market volatility. While the investor has increased control over the asset allocation, the VA may be purchased for growth, income, tax deferral, and death benefits.
  
  
• Equity index annuities (EIA) – Policies that are generally linked to an identified market index but are not directly invested in the market itself. Usually, these products offer different investment options as well as a fixed interest account. These products offer complete downside protection with limited upside potential.

• Hybrid annuities –VAs with modified EIA features. They are designed to offer more upside potential and some downside protection. Hybrids are often referred to as buffered products.
  
  
• Annuities with long-term care benefits – Policies that provide higher distribution rates for those who qualify for extended healthcare benefits.

Now it can get even more complicated from here. Annuities can be customized further with riders that solve for specific needs: income, rising income, death benefit, long-term care, and spousal protection for benefit continuity. You may need help finding a suitable annuity or reviewing older ones you already own. Your needs may change over time and product features evolve, as well.

The following is a very simple example that highlights how needs evolve and solutions may need to be updated. It does not reflect other portfolio investments and risk management. In this example, you are 52 years old, concerned about market declines, risk averse for this part of your portfolio, and you choose to purchase an EIA without any riders. An EIA provides market linked performance credits with zero downside participation. Ten years later, at 62, you are planning to retire within five years. Your focus changes from preservation of principal with conservative growth to an investment that will provide rising income for life for both you and your spouse. Decisions need to be made. Prioritizing your needs, while considering the market and economic environments, may support another type of annuity or another income-generating strategy. Depending further on your preferences and in coordination with the rest of your retirement income plan, you might consider either a new EIA with rising income and spousal protection riders or a hybrid annuity with similar benefits. Please note that the first annuity met the required need for the initial accumulation goal and the second one would be more appropriate for income generation in retirement. In this situation, you initially desired market-linked exposure for performance with no downside and your needs later required a flooring strategy that would provide income and protection against longevity risk (outliving your money!!!).

So why do annuities work in retirement income planning? Here are some of the reasons:

• They act as an effective flooring strategy and can serve to help meet minimum spending needs. As previously stated in Chapter 13, flooring strategies such as annuities can provide and stabilize utility theory, your happiness quotient, measured by spending and the availability of money.
  
  
• They can provide certainty, comfort, and peace of mind in all types of market volatility.
  
  
• They can provide income for life, either for individuals or married couples.
  
  
• Annuities with guaranteed income benefits are considered low risk investments. Therefore, they can be used for diversification, as a conservative part of the portfolio.
  
  
• SPIAs can offer guaranteed inflation protection. Other annuities with rising income riders provide inflation protection depending upon market performance.
  
  
• As mentioned in previous chapters, annuities can mitigate certain retirement risks such as longevity, sequence of return, excess withdrawal, and those that may arise from market volatility. However, they do limit liquidity and growth in a portfolio at the same time. Therefore, finding a good balance is important in the planning process.
  
  
• Annuities complement other guaranteed income sources in a flooring strategy particularly for more risk-averse investors.
  
  
• Annuities with income benefit riders are designed to generate sustainable distribution rates, often higher and longer than what is available when converting other assets into income. When an investor takes distributions from such annuities, these higher withdrawal rates should deplete principal over time. Yet, when used properly, they will continue to provide income.
  
  
• Annuities may increase flexibility for an overall retirement income plan, allowing other assets either to not be depleted, or to be used in other ways. Such additional assets may be used with greater confidence for emergency reserves, legacy goals, or, simply, to spend more.
  
  
• Experienced financial advisors often incorporate multiple products to meet investors’ unique needs. They may also use different financial institutions to provide institutional diversification.

On the whole, there are many quality annuity products. Competition in the industry is strong and, therefore, product features are constantly being changed and upgraded. Quality financial advisors will be invaluable in helping you assess what is right for your specific situation. They will cover product costs, rider fees, and the pros and cons of each annuity option.

Using an annuity may reduce the amount of distributions needed from systematic withdrawals and bucketing strategies and may stabilize income. They may even provide confidence to invest more in equities for higher growth potential elsewhere in your portfolio. In certain households, annuities may not be needed at all.